You have been saving money for some time now, and are finally ready to purchase a new home. Congratulations! Now the question is: how much home can you afford to buy?
Consider the viewpoint of mortgage lenders. Lenders will want to feel confident that you can make regular monthly payments. To determine this, they compare your regular monthly income (before taxes) from all sources versus your regular monthly expenses to create a debt-to-income (DTI) ratio. For example, if you make $2500 per month and have regular expenses of $500, your DTI is $500/$2500, which equals 0.2 or 20%.
DTI may be calculated as a "front-end" DTI, including only your total housing expenses (principal and interest, insurance, and taxes), but the typical DTI is a "back-end" number, including all of your expenses – housing plus credit cards, car payments, tuition, child support and any other payment with a running component.
Generally, the maximum back-end debt-to-income ratio for a loan is 36% (front end is typically 28%-33%). Beyond that, the loan is considered risky. Federal programs such as FHA or VA loans can handle higher DTI numbers, but we suggest being conservative while estimating affordability.
There are many home affordability calculators online that help you calculate your DTI and evaluate different scenarios. They vary in complexity, but for most meaningful ones you will need the following numbers along with income and expense information.
- Down Payment – Down payments of less than 20% will require private mortgage insurance (PMI) to cover the perceived risk. Usually this is around 1-2% of the loan principal per year. Check to see if the calculator you use includes PMI automatically with a down payment of less than 20%, or if you have to add it separately.
- Loan Term – The length of the loan, usually 15 or 30 years.
- Loan Type – Many calculators assume a fixed rate. If you are given options, stick with the fixed rate to be conservative.
- Interest Rate – Use the current fixed-interest rate, and add a few tenths of a point if you want to be conservative. It may go up by the time you buy.
- Taxes – Several places online allow you to get average property taxes by zip code. A rough estimate is $3,500 per year.
- Insurance – This is homeowner's insurance, separate from PMI. A rough estimate is $500 per year.
- Other Expenses – In essence, this is how much slack you want to give yourself for non-regular, unexpected expenses that may not be captured (such as furnishing a brand new house). Future debts like college tuition and contributions to retirement plans are other good examples.
Remember, the calculator is estimating costs over the whole term of the loan, and it assumes steady income. Be conservative with your estimates.
The calculators will tell you the amount of home you can afford, and usually what your monthly payments will be. Don't be shocked if the affordability number seems low.
For example, using Zillow's calculator, with a $60,000 per year income, $1,000 in monthly expenses, a 30-year fixed rate at 4.6% and a $20,000 down payment, you only can afford a $127,503 home. Increasing income to $70,000 improves affordability to $173,266, but cut the monthly expenses in half and affordability increases to $199,463.
Wrapping up, to find out how much home you can afford, summarize your income and expenses, make conservative adjustments for unexpected expenses, and use an online calculator to test scenarios. If you don't like the number you get, the best thing you can do is to lower your debts and monthly expenses, or search a bit harder for a home you can afford today.